Book vs. fair value accounting in banking and intertemporal smoothing

The aim of this paper is to examine the pros and cons of book and fair value accounting from the perspective of the theory of banking. We consider the implications of the two accounting methods in an overlapping generations environment. As observed by Allen and Gale(1997), in an overlapping generation model, banks have a role as intergenerational connectors as they allow for intertemporal smoothing. Our main result is that when dividends depend on profits, book value ex ante dominates fair value, as it provides better intertemporal smoothing. This is in contrast with the standard view that states that, fair value yields a better allocation as it reflects the real opportunity cost of assets. Banking regulation play an important role by providing the right incentives for banks to smooth intertemporal consumption whereas market discipline improves intratemporal efficiency.Banking, shocks, insurance, intertemporal, Overlapping Generations Equilibrium

Credit Risk and Discontinuous Effects of Monetary Reverse Transactions

A central bank possesses various instruments to provide liquidity. These are either outright monetary transactions (OMT) of securities or other refinancing facilities, primarily repos, which are executed with standard tenders. The eligible securities (i.e. bonds or equities) need to conform with certain credit risk criteria (i.e., satisfactory credit rating or low default probability). This paper introduces a monetary model to address the role of collateralized securities on the effectiveness of monetary policy. Our results suggest that credit rating downgrading may precipitate into a disproportionate credit contraction

On Bankruptcy in General Equilibrium with Uncertainty

In a general equilibrium model with time and uncertainty the possibility of bankruptcy cannot be excluded in general, when short sale constraints are too loose. Tight short trading constraints, on the other hand, are inefficient. Bankruptcies turn security payoffs endogenous and destroyconvexity of the induced preferences over portfolios. The latter raises existence issues for competitive equilibrium, as illustrated in this paper by an example

Evaluation of macroeconomic models for financial stability analysis

As financial stability has gained focus in economic policymaking, the demand for analyses of financial stability and the consequences of economic policy has increased. Alternative macroeconomic models are available for policy analyses, and this paper evaluates the usefulness of some models from the perspective of financial stability. Financial stability analyses are complicated by the lack of a clear and consensus definition of ‘financial stability’, and the paper concludes that operational definitions of this term must be expected to vary across alternative models. Furthermore, since assessment of financial stability in general is based on a wide range of risk factors, one can not expect one single model to satisfactorily capture all the risk factors. Rather, a suite of models is needed. This is in particular true for the evaluation of risk factors originating and developing inside and outside the financial system respectively.Financial stability; Banks; Default; Macroeconomic models; Policy

The best way forward for Greece is a major debt restructuring and a ‘hard’ budget constraint

Talks are continuing between Greece and its creditors in advance of a scheduled Greek debt repayment to the IMF on 30 June. Charles Goodhart and Dimitrios P. Tsomocos argue that the best way forward for Greece would be to undertake a major restructuring of Greek debt and to enforce a ‘hard’ budget constraint on all future public expenditure

Evaluation of macroeconomic models for financial stability analysis

As financial stability has gained focus in economic policymaking, the demand for analyses of financial stability and the consequences of economic policy has increased. Alternative macroeconomic models are available for policy analyses, and this paper evaluates the usefulness of some models from the perspective of financial stability. Financial stability analyses are complicated by the lack of a clear and consensus definition of ‘financial stability’, and the paper concludes that operational definitions of this term must be expected to vary across alternative models. Furthermore, since assessment of financial stability in general is based on a wide range of risk factors, one can not expect one single model to satisfactorily capture all the risk factors. Rather, a suite of models is needed. This is in particular true for the evaluation of risk factors originating and developing inside and outside the financial system respectively.Financial stability; Banks; Default; Macroeconomic models; Policy

A Strategic Market Game with a Mutual Bank with Fractional Reserves and Redemption in Gold (A Continuum of Traders)

We utilize the strategic market game approach to analyze the role and function of a mutual bank with variable fractional reserves, redemption in gold and endogenous interest rate formation. We specify the conditions of enough money and its distribution. Using the continuum of traders model, we show existence and optimality for the case of no bankruptcy as well as for the case in which there exists the potentiality of bankruptcy. Finally, we analyze the relationship of the gearing ratio and the bankruptcy penalty with respect to the resulting equilibrium allocations

Capital Flows, Default, and Renegotiation in a Small Open Economy

The post-2008 period focused attention on "twin-crises". Banking crises may lead to sovereign crises where fiscal vulnerabilities are exacerbated by the extension of support for the banking system. We develop a model that describes private sector generated capital inflow that is used to finance investment and consumption expenditure. In the event of an economic contraction, the (convex) haircut on outstanding debt is negotiated, or bargained, centrally by the sovereign. Two results arise: the volume of debt and haircut rate are inefficient. In this setting the accumulation of capital achieves two goals. First, it generates sufficient optimism about future income to allow the debt market to function. Second, and counter-intuitively, it increases expected haircuts by raising the value of the outside option of complete default. These competing forces characterize the optimal balanced-budget macroprudential policy targeting capital investment

Debt Deflation Effects of Monetary Policy

This paper assesses the role that monetary policy plays in the decision to default using a General Equilibrium model with collateralized loans, trade in fiat money and production. Longterm nominal loans are backed by collateral, the value of which depends on monetary policy. The decision to default is endogenous and depends on the relative value of the collateral to face value of the loan. Default results in foreclosure, higher borrowing costs, inefficient investment and a decrease in total output. We show that pre-crisis contractionary monetary policy interacts with Fisherian debt-deflation dynamics and can increase the probability that a crisis occurs